Understanding the relationship between risk and return is fundamental to making appropriate investment choices. Simply stated, it is: the greater the risk associated with an investment, the greater the potential return. Conversely, the safer an investment is, the less potential return it offers. This principle governs all investments from savings accounts to government bonds to stocks.
When investing for short-term goals, those less than one year away, investments that provide less return, but also less risk, are appropriate. Short-term goals can include scheduled car repairs, paying taxes, or travel. Since you will need your invested money relatively soon, you should be more concerned with protecting your money than growing it. In this case, an FDIC-insured savings account is probably your best option. Because this investment is stable, the value of your account won’t fall just as you are about to withdraw your money, and because it is ‘liquid,’ you have easy access to your money. While savings accounts offer a lower return than other types of investments, because they are insured by the FDIC, they are very safe.
Investing for medium-term goals, those from one to three years away, can be tricky because you need to balance risk and return. Medium-term goals might include buying a new car, having money for a PCS, or starting a family. If you choose medium-term investments that are too safe, you may not get enough growth to keep pace with inflation. If you choose investments that allow for growth, you may not have time to recover from a downturn in the market. Consider investments that offer a good compromise between growth and stability, such as CDs and brokerage accounts. Also, savings accounts are a good option for getting started.
When investing for longer-term goals, those more than three years away, you probably want to risk periodic volatility for longer-term gains. These goals might include buying a house, saving for a child’s college tuition, or retirement. The further into the future a goal is, the more growth-oriented your investments can be. Given a long-enough investment window, periodic downturns in the market are usually offset by long-term market gains. Long-term investment options, such as the Thrift Savings Plan, IRAs, or a 529 college savings plan, typically have tax advantages that allow you to maximize long-term compounding of interest.
A final consideration when balancing risk and return is your own personal tolerance for risk. If downturns in your investments keep you awake at night—even if you are years from ‘cashing out’—you may wish to err on the side of less risk in your investments. Keep in mind, though, that no investment choice is risk-free. Use a stable investment, such as a savings account, to save for long-term goals and you run the risk of your return not keeping up with inflation.
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